Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/101174 
Year of Publication: 
2014
Series/Report no.: 
ADBI Working Paper No. 456
Publisher: 
Asian Development Bank Institute (ADBI), Tokyo
Abstract: 
We present a theoretical framework for policy making based on the "impossible trinity" or the "trilemma" hypothesis. A simple optimization model shows that placing more weight in terms of preference for each of the three open macroeconomic policies - exchange rate stability, financial market openness, and monetary policy independence - contributes to a higher level of achievement in that particular policy. We then develop the first empirical framework in the literature to investigate the joint determination of the triad open macroeconomic policies based on the trilemma hypothesis. Specifically, we estimate the three policy indexes under the trilemma constraint that they must add up to a constant. By applying the seemingly unrelated regression (SUR) estimation method and employing other robustness checks, we demonstrate that simple economic and structural fundamentals determine the trilemma policy combinations. Last, we examine how deviations from the "optimal" trilemma policy combinations evolve around the time of a financial crisis. Policy combinations seem to violate the trilemma constraint when a currency, banking, or debt crisis breaks out. These findings suggest that deviations from the trilemma hypothesis would create policy stress, which would have to manifest itself in a crisis unless policy makers adjust the policy combination in a way consistent with the trilemma constraint.
Subjects: 
trilemma hypothesis
macroeconomic policy
exchange rate stability
financial market openness
monetary policy independence
financial crisis
policy combination
JEL: 
F15
F21
F31
F36
F41
O24
Document Type: 
Working Paper

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